Understanding the need to establish and maintain an emergency fund is paramount to securing financial stability. This article aims to provide insights into how to determine the size of your emergency fund based on your specific circumstance and factors such as income stability, essential expenses, and risk tolerance. We will also dig into supplementary considerations such as property ownership, unplanned expenses, and where to ideally locate your emergency fund so that you will be prepared for any financial surprises that life might throw your way.
One Size Does Not Fit All
Determining the size of your emergency fund is an individual (or family) specific exercise. Sure, there are “rules of thumb,” but it comes down to your particular situation. Consider starting with your budget or at least reviewing what monthly expenses you’d need to cover should you lose a source of income. Consider the differences between essential and discretionary expenses and the extent to which you’d need to cover both types of costs. Set realistic expectations about which expenses you could feasibly cut under pressing circumstances.
Next, consider how many months of expenses are appropriate to set aside. Factors to consider include the number of household incomes, the nature of your income (e.g., stability, predictability, etc.), and your personal risk tolerance when determining the month’s worth of living expenses you’d like to set aside. It would be best to consider upcoming life events such as marriage, children, spouse returning to work, or new sources of income such as social security, pension, or annuity that need to be factored into your emergency fund. Remember, guaranteed sources of income may decrease the required amount you need in an emergency fund.
If you own (or plan to own) rental property or are a business owner, there are other factors to consider. Additional rental-related expenses such as mortgage, taxes, repair, utilities, tenant vacancies, and rental income should be considered when calculating your emergency fund. It might also be wise to keep a separate rental property emergency fund. Similarly, if you are a business owner, consider business-related expenses, including payroll and business income.
Unexpected Expenses (are to be expected)
Everyone has unexpected expenses (car repairs, home repairs), either from accidents or breakage. Consider adding your insurance deductibles to your emergency fund in the case of accidents. Adding a buffer for potential home repairs or appliance replacement costs is also helpful, as your insurance generally does not cover them.
Along the same lines, if you are concerned about potential healthcare expenses, consider your health insurance deductible or out-of-pocket maximum and factor that into your target emergency fund. Another good thing to know is the elimination period (waiting period) of your disability insurance policy (short-term and long-term disability), as you’ll want to make sure your emergency fund is big enough to carry you to the point in which your insurance kicks in.
If you are concerned that it would be difficult to quickly replenish your emergency fund should you need to use it, you should consider any asset/debt flexibility (HELOC, reverse mortgage, 0% credit card balance transfers, 401(k) loans) that could be used as a backup emergency fund while you replenish your primary emergency fund.
Where do I put it?
Hint – not under your mattress. Before going there, knowing whether your emergency fund is underfunded probably makes sense. If this is the case, think about whether you could optimally reposition or sell certain assets/holdings to finish funding your emergency fund. Be mindful of how this may impact your investment and tax planning goals.
If most of your emergency fund is held in checking or savings accounts, consider whether your emergency fund could be better positioned using high-yield savings accounts or short-term CDs for keeping up with inflation. Or perhaps most of your emergency fund is held in retirement or brokerage accounts -if so, consider whether your emergency fund has enough flexibility (e.g., liquidity, manageable tax consequences) to meet your needs should an emergency occur. If you have assets in a retirement plan, you may be eligible to take a penalty-free “emergency withdrawal” of up to $1,000 (once per year, and you can’t use it again until paid back or three years have passed).
Other locations for emergency funds can include health savings accounts (for medical expenses), Roth IRAs (contributions can be taken out tax-free), and permanent life insurance (cash value). If you have any safe assets that are currently illiquid but will gain liquidity in the future (e.g., I bonds, CDs, deferred annuities), think about earmarking a portion of those assets as part of your future emergency fund once they gain some liquidity.
Lastly, consider if your employer offers an emergency savings account as part of your retirement plan benefits and you are not considered a highly compensated employee. If so, consider whether contributions to this account (including employer matches) would complement your emergency fund appropriately, but be mindful of any applicable limitations.
Coordinating with Other Goals
You may be trying to coordinate creating (or maintaining) your emergency fund in light of other goals such as paying down debt, doing Roth conversions, or other savings goals such as retirement or education savings. If you are in debt reduction mode, consider the extent to which paying off, refinancing, or consolidating your debts could reduce your monthly payments toward debt obligations and how that may complement your situation by reducing the demand on your emergency fund that may otherwise need to cover such expenses.
If one of your financial goals is making a Roth conversion, think about the extent to which Roth assets may complement your emergency fund needs by giving you greater tax flexibility. Regarding other savings goals – prioritizing which savings goals should be cut or preserved should you need to divert cash flow to replenish your emergency fund. Be sure to consider additional planning benefits that could be impacted by making cuts to your savings goals, such as employer match or tax deductions.
Conclusion
Understanding and establishing an emergency fund is crucial to guarding your financial stability against unexpected life events and expenses. This practice requires not only an evaluation of personal circumstances like income stability and risk tolerance but also thoughtful consideration of potential adjustments in assets owing to life events or unexpected business expenses.
WHWM is here to guide you in identifying your priorities, developing a plan, and making adjustments along the way. By choosing WHWM, you're partnering with our Founder and President, Stephen Bodwell. As a CPA and CFP® professional, Stephen is committed to helping you achieve your financial goals and aspirations. Don't hesitate to take the next step toward realizing your dreams. Schedule your complimentary, no-obligation 30-minute consultation with Stephen.
Walnut Hill Wealth Management, LLC (“WHWM”) is a registered investment advisor offering advisory services in the State of Texas and in other jurisdictions where exempt. The information provided is as of the date indicated and is subject to change.
Comments